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Comparing Copper/Gold Ratio To The Ten Year Treasury Yield And Discussing Fixed Income Allocation For The Next 24 Months

Summary

Copper/Gold Ratio has empirical evidence to be used as proxy for Ten Year Treasury Notes since the beginning of the last economic cycle;

The distance between copper and gold widened since Trump's election;

A reduction of the spread between copper/gold gives more arguments to believe that Ten Years treasury might reduce the yield;

Downside: a Fed not worried to take the punch bowl away under a slowdown or spike in expected inflation;

Upside: being able to allocate 10 years Treasury notes and to take future advantage of High Yield notes under stress.

Comparing Copper/Gold Ratio To The Ten Year Treasury Yield And Discussing Fixed Income Allocation For The Next 24 Months

Looking at last year’s Gundlach presentation I decided to compare the 10 years yield to copper/gold again...according to him this is a good indicator for the next movements of the 10 years yield (I interpreted that Copper/Gold is the leader variable). 

The result is interesting :

It is rare to see the 10 years yield breaking the copper/gold. It is 200 bps above. I don't know the correct level of retraction but using the evidence, either the yield is supposed to come down in the next few months or (kind of obvious but turning around the leading variable to TNX) gold is supposed to come closer to copper (which indirectly could mean a weaker dollar/ higher expected inflation in my opinion). 

So, what if a slowdown starts to make headlines (we have been watching positive cycle expansion for 9 years, how long is it going to take for a slowdown?) 

Then, I would consider small monthly allocations on the 10 years for the next 12 months a good long term strategy.

There is a plus: The cost of future leverage is cheaper if you have a good entry price on your 10 year notes and it can be used to buy good HY picks, definitely a plus to recover any opportunity cost of missing the peak of the 10 years yield.

My only concern with this strategy would be if Jerome Powell is actually a different kind of guy, someone who goes against Greenspan style of monetary policy and which the market hasn't seen in more than 30 years...who doesn't care about the stock market and will "take the punch bowl away" in this case, he won't reduce the pace of rate increases until the 2.75% in the next 24 months which could hurt the strategy, however, considering that 2020 is election year I don't know if this would be the case.

Let's check the graphs:

1) Graph Copper/Gold vs TNX since 2010 and the breakout mentioned:
The candles (green and red) is the copper/gold ratio, the orange line is the TNX (CBOE 10 years YIELD)

2) Graph: Copper vs GLD since 2016's November election with higher expectations on global growth + US construction/infrastructure putting copper 48.72% up to date and gold only 2% which could make the recent correlation on graph 1 be false. In this case, the distance between Copper and gold should reduce and the TNX could be even more backed by these kinds of arguments to go further down in the recent future.

3) The BofAML US HY option adjusted spread of High Yield and Treasury started to point upward again, last time this trend confirmed, we saw from June 2015 to February 2016 a lot of stress in the high yield notes and a great time to buy not so long duration, I remember seeing some interesting notes like Gerdau 23 paying 9% and CSN paying 25%.

ERALDO DE PAOLA

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Disclosure: I am/we are long GLD, IEF.

Additional disclosure: This is not an investment advice.